Dear MoneyNews Reader:

George Soros is renowned for his macro-views on the economy, currencies and commodity markets. He operates in the playground of the rich and doesn’t mind swinging for the fences when his analysis tells him that he’s onto something big.

Back in 1990, when I was cutting my teeth as a young buck in London’s money markets, Soros was formulating on how to take on one of the world’s oldest central banks.

It was that year that Prime Minister Margaret Thatcher announced the immediate entry of the U.K in to the Exchange Rate Mechanism (ERM). Several weeks later she resigned under party pressure.

So convinced was he that the Bank of England would be unable to maintain the value of the British pound that he spent much of the next two years building a position speculating that his view would outwit that of both the British government and the mandarins at the Bank of England.

As legend has it Soros’ Quantum Fund built up a position of such magnitude selling short the British pound in favor of the German mark, that by the time the battle was over, he’d grossed a profit of a billion pounds as he bought back his short position in the British currency.

Most of the money went back to his native Hungary to help poor orphans, as the billionaire philanthropist is hasn’t been short of a penny for many a year.

You hear much about these big-swinging hedge fund managers, with their legendary positions of such size that the mere whisper of them entering a market is enough to move it!

For every legendary hedge fund manager there must be several dozen successful traders in the major financial centers whose success goes unnoticed except by their desk manager. In my own trading days in London my annual targets were pretty lofty – set at around $2.5 million. I have the grey hairs to prove my success.

They had him in the dock and judged him guilty of ‘insider trading’ because he’d acted on a rumor on that Friday afternoon in October 1990. Many peers alleged that this trader had plundered their trading books and cleaned up in the space of the last fifteen minutes of trading that day leaving them high and dry when the Treasury announced the swift change in British policy.

I’m not going to reveal his identity as he’s since retired from the banking world altogether. Let’s just call him ‘John.’ I remember the first time we met at a chic city wine bar, where John was holding court with several of his brokers and colleagues. He knew how to tell a tall story and was the least likely city banker you could meet. 

Absolutely down to earth, a native south Londoner from humble origins and a fierce rugby player, John was a real practical joker.

I found out that John and I lived pretty close and we’d take the same 6.30am train into the city each morning. Before long we’d share each other’s newspapers on the way into work and share our insight into the money and currency markets as we crossed London Bridge across the freezing waters of the River Thames. In the winter months it would still be dark as we arrived at our offices.  

John steadfastly refused to comment about the ERM debacle that had alienated him from so many city traders. In his eyes he’d done nothing wrong. The millions of pounds he’d earned for his bank were done so quite legitimately and within the framework of the rules at the Bank of England.

It wasn’t until several years later and shortly before I hopped on a p*** to settle in the United States that John finally spilled the beans as to what happened that day.  It was no small controversy either. While the news was the buzz in the city of London, within three months it was making national news. Here’s what The Independent newspaper said shortly after the affair blew up.

“This week, there have been persistent stories in the money markets that some firms have been angered by losses they made on deals done in Floating Rate Agreements just before the official announcement.” The Independent October 21, 1990.

And those deals weren’t small potatoes either. According to a Member of Parliament as reported in the Financial Times,  “He said the allegations suggested that Gerrard & National bought Pounds 35million of forward foreign exchange contracts - compared with their normal daily trading of Pounds 2million to Pounds 5million - invested a further Pounds 100 million in the UK government bond market.” FT Jan 16, 1991. 

You see the timing of the announcement came as trading had all but finished for the day in the pretty liquid market for interest rate futures. So many traders entered into positions in a traditional afternoon frenzy only to find themselves stuck with positions they couldn’t unwind once the decision had been made. The Treasury announced the level at which the pound would enter the system as well as an unexpected interest rate cut.
 
But where the bank really made its money hand over fist was in John’s specialist area. He was the forward rate trader. These complex derivatives locked traders into interest rate commitments with other banks in vast notional amounts. According to The Independent, “[Gerrard’s] increased its exposure to sterling forward rate agreements by a further Pounds 1billion.” 

With that kind of position size in a one-year forward rate contract Gerrard’s could have stood to benefit from a Pound 10 million profit over the weekend, at the expense of traders around the city. So you can see why other traders might have been a little hot under the collar.

Complaints were lodged against Gerrard and National Discount House to the Bank of England. A Parliamentary motion was tabled to investigate whether a specialist bank had dealt on inside knowledge and profited handsomely by doing so. More over highbrow banking officials had wanted to know why they had been exploited.

I can tell you that back at that time, we all knew that Britain would join the ERM. No one knew quite when. In 1990, few people felt that the economic environment was right for Britain to join. The biggest worry was whether the pound could hold its own against the mighty German mark. If the entry rate at which the pound was set too high it could put interest rates under pressure and cause the economy to fail.

In other words it was felt that the time wasn’t right for the U.K. to join forces with Europe. So few traders were betting on it at that time.

However, Gerrard’s felt that the decision would come over a weekend and that as such it would be a surprise when it was announced. So with alarming regularity each Friday they’d take some sizeable positions in the market in the hope that one weekend they’d hit the jackpot.

However, I can tell you that not every weekend did they roll out the big guns as they did on October 5th, 1990.

Let me give you some background on the role of a ‘discount house’ in London’s money markets.

These specialist institutions used to be the buffer between the Bank of England and the big four clearing banks. Those major banks would then deal with the rest of the banking system. While the discount houses were pretty small, they had incredible weight in the market and would often have some insight into what the Bank of England was up to on a day-to-day basis.

Because their role was to act between the top tier of major banks and the Bank of England, there was an historically intimate role between senior traders at the discount houses and their counterparts. For some reason, the messengers at these houses would walk from bank to bank borrowing and lending major sums of money as written on a banker’s draft of acceptance. To maintain their importance these characters would wear extremely distinguished dress.

A messenger would typically wear a tall, black top hat and tails of a soft salmon color. These men would look better in place in a Dickensian story, but blended right into life in the city of London even just ten short years ago. People were so accustomed to see them bustling between banks that they rarely batted an eyelid.

These messengers would wander from the discount house to other banks and finally the Bank of England where they would borrow, deposit and tender bids for money at the bank’s prevailing rate.

Here’s what really happened that day in October. As usual Gerrard’s was wondering what might happen that coming weekend. Nothing untoward was occurring. The messengers were out and about as usual on Friday, when one out of breath chap rolled back into the office having rushed back from the foyer at the Bank of England on Threadneedle Street.

He gushed out his words to the directors in the office. The Bank’s own messengers and staff were running around the foyer at the Bank like headless chickens!

Never before had he witnessed such a hive of activity as mandarins rushed around the hallowed halls following orders and falling over one another.

The messenger had already twigged what was going on and so to had the directors. Clearly the melee going on at the central bank was on account of an unexpected change that only those who needed to know were aware of.

The directors instructed the dealing staff to implement the plan of action. Immediately each of them took to their ‘phones, Reuters communications devices and plunged headlong into the market before anyone else got wind of the news. Of course any of the other discount house messengers might have noted the same commotion at the Bank of England.

If someone else acted on that information the gig would be up.

John’s forward rate book was the piece de resistance in all of this. It was a pretty liquid market at the time and to enter a few simple trades of the maximum one-year duration was the most efficient way to enter the market at the time.

It took a few calls to one or two trusted brokers, one or two Reuters calls to other major counterparts – to other leading players – and the deed was done.

One BILLION pounds worth of deals in under fifteen minutes. From what I recall of that afternoon, the market suddenly got locked into a frenzied upswing as traders began to fear that the rumor was much more than a rumor. When news of the size of the trades was confirmed by futures brokers, bond and money brokers, big-time bankers began to jump on the back of the move in the belief that only a fool would make a bet of such proportion with only a grain of knowledge about what was going on.

It was only minutes later when the markets were locked on the way up that confirmation came in an emergency press conference by the British Treasury to tell the city of London their strategy for the pound, interest rates and the economy during the course of the weekend.

Was it insider knowledge? I’m not sure it was. Certainly Gerrard and National was in a privileged position to witness the mêlée at the Bank that afternoon. But they were prepared each weekend to act that way in order to capitalize on a sure-fire winner.

John had followed his orders and executed the directors’ wishes. It left him a richer man if not in monetary terms, certainly in spirit following the excommunication he encountered.

John left the city several years later disillusioned with life as trader.